Buhata
Login Start for Free

Home › Life Terms

Saving and investing basics

Tax-advantaged account

An account the tax code rewards, such as a 401(k), IRA, HSA or 529 plan, where taxes are cut, delayed or skipped if you follow its rules.

What It Means

A tax-advantaged account is a savings or investment accountBrokerage accountAn account at a brokerage firm that holds your cash and the stocks, bonds, funds and ETFs you buy and sell through that firm. See more that the tax code treats more kindly than an ordinary one, as long as you use it for its purpose. In a tax-deferred account, such as a traditional 401(k)401(k)A retirement plan run through an employer that lets you put part of each paycheck into investments, before tax or as Roth, up to a yearly IRS limit. See more or IRATraditional IRAAn individual retirement account where contributions may be tax-deductible, growth is tax-deferred, and withdrawals are taxed as income. See more, you pay tax later, when you withdraw. A tax-exempt account, such as a Roth IRARoth IRAAn individual retirement account funded with after-tax money, where qualified withdrawals, earnings included, come out tax-free. See more, lets qualified withdrawals come out tax-free. Each type comes with limits on how much goes in and rules on when money can come out.

Try It: Flip Each Account to See Its Tax Break

Tap each account to see when its tax break arrives and what the catch is.

Traditional 401(k) or IRA

Break comes now. Contributions can lower this year's taxable income, and growth isn't taxed yearly.

Catch: withdrawals are taxed as income, with a 10% additional tax before 59½ unless an exception applies.

Roth 401(k) or Roth IRA

Break comes later. You pay tax going in; qualified withdrawals, growth included, are tax-free.

Catch: earnings must wait for the five-year rule and age 59½.

Health savings account (HSA)

Break comes three times. Deductible going in, untaxed growth, tax-free out for qualified medical costs.

Catch: needs HSA-eligible health coverage; non-medical use before 65 adds a 20% tax.

529 education plan

Break comes on the way out. Growth isn't taxed, and withdrawals for qualified education costs are tax-free.

Catch: the tax-free part applies to qualified education costs.

Regular brokerage account

No special break. Investment income is taxed under the normal rules.

Upside: no limits, and you can take money out at any time.

How People Say It

  • "Max out the tax-advantaged accounts first."
  • "That money's in the Roth, so leave it alone."
  • "We keep the HSA for medical bills only."

The Breakdown

The family. The Okafors, both 42, save in five places: a 401(k) at work with a match, an old 401(k) from a previous job, a Roth IRA each, a family HSAHealth savings accountA tax-advantaged account for medical costs, open to people with an HSA-eligible health plan, where money goes in, grows and comes out for care without federal income tax. See more, and a 529 plan529 planA state-sponsored, tax-advantaged account for education costs, where growth is free of federal income tax when spent on qualified expenses. See more for their daughter. Each account gives a different tax break, and each has its own rule about taking money out.

Where it went wrong. When the car needed an $8,000 repair, they had no ordinary savings set aside and took the money from the old 401(k). Because they're under 59½ and no exception fit, the IRS added a 10% additional taxEarly withdrawal penaltyThe IRS 10% additional tax on money taken from a 401(k), IRA or similar account before age 59½, unless an exception applies. See more of $800 on top of income tax on the full $8,000. A few months later they paid for a new phone from the HSA, which, before age 65, is taxed as income and owes a 20% additional tax. Both accounts did what they promise; the money came out for a purpose the rules don't reward.

AccountWhen the tax break arrivesEarly or wrong-use cost
Traditional 401(k) or IRANowIncome tax, plus 1010,000 stepsA popular daily step goal that began as the name of a 1960s Japanese pedometer; later studies find health benefits begin well below it. See more% before 59½
Roth IRALaterTax and 10% may apply to earnings
HSANow, while growing, and out for medical costsIncome tax, plus 20% before 65
529 planWhile growing and out for educationEarnings may be taxed if used for other costs

What to watch for

  • Keep an emergency fund in ordinary savings, so a surprise bill doesn't come out of a retirement account.
  • Know each account's purpose before you open it, and use it for that.
  • Check each year's limits on irs.gov, since several change annually.

Good to Know

Investor.gov, the SEC's site for investors, sorts these accounts into two groups: tax-deferred, where you pay tax when money comes out, and tax-exempt, where qualified withdrawals come out tax-free. The exact rules differ by account and change with new laws, so read the account's own IRS page or ask a tax professional before withdrawing early. For 529 plans, your state's plan explains its own rules and any state tax benefit.

FAQ

What are examples of tax-advantaged accounts?

Traditional and Roth 401(k)s and IRAs, health savings accounts and 529 education plans are the common ones. Investor.gov describes how each defers or eliminates tax on investment earnings.

What's the difference between tax-deferred and tax-exempt?

A tax-deferred account, like a traditional IRA, lets you pay the tax later, when you withdraw. A tax-exempt account, like a Roth IRA, taxes the money going in and lets qualified withdrawals come out tax-free.

Can I take money out of a tax-advantaged account whenever I want?

Usually you can, but the tax break depends on following the rules. Withdrawing from a 401(k) or IRA before 59½, or using HSA money for non-medical costs before 65, generally adds tax.

Do It in Buhata

Accounts

List each tax-advantaged account separately in Accounts, with its purpose in the name ("HSA, medical only"), so everyone in the household knows which money is for what.

Open Buhata

Related Terms and Categories

  • 401(k)

    A retirement plan run through an employer that lets you put part of each paycheck into investments, before tax or as Roth, up to a yearly IRS limit.

  • Roth IRA

    An individual retirement account funded with after-tax money, where qualified withdrawals, earnings included, come out tax-free.

  • Traditional IRA

    An individual retirement account where contributions may be tax-deductible, growth is tax-deferred, and withdrawals are taxed as income.

  • Health savings account

    A tax-advantaged account for medical costs, open to people with an HSA-eligible health plan, where money goes in, grows and comes out for care without federal income tax.

  • 529 plan

    A state-sponsored, tax-advantaged account for education costs, where growth is free of federal income tax when spent on qualified expenses.

  • Brokerage account

    An account at a brokerage firm that holds your cash and the stocks, bonds, funds and ETFs you buy and sell through that firm.

Saving and investing basics

Sources

Investor.gov (SEC), "Tax-Advantaged Accounts"; FINRA, "Understanding Tax-Advantaged Investment Accounts"; Charles Schwab, "What Is a 529 Account? How It Works and Tax Rules"; Internal Revenue Service, "Topic no. 558, Additional tax on early distributions from retirement plans other than IRAs"; IRS, "Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans"

Last updated .